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Why We Need The Government To Play An Active Role in Higher Ed

This post first appeared at Forbes, where I am now a contributor. You can read it there. Or here.

These days, everyone knows that college is expensive. And everyone has their own idea of how to fix it. When it comes to higher education finance, we’ve become a nation of backseat drivers.

Allow me to drive in the backseat here. College is expensive, and the government’s attempts to help make college more affordable for students has likely driven up prices even more. But there is a solution: Rather than remove itself from higher education, as many libertarian economists have suggested, we actually need — and want — the government to play a larger and more prominent role.

Higher education prices have risen far faster than other prices in the economy: across all institutions, undergraduate tuition, fees, and living expenses more than doubled in inflation-adjusted dollars. At private nonprofit four year schools, tuition and fees have nearly tripled compared to 40 years ago, while at four year public schools costs have almost quadrupled over the same time frame. Public two-year schools, which experienced a huge drop-off in state funding in the wake of the recession (and where most of the higher education in this country takes place), have seen tuition and fees grow nearly 50% in the last decade. Bloomberg estimates that the price of college has increased twice as much as that of medical care since 1978. In short, college has become more expensive – and the price continues to increase.

Tied into all of these is that the government has one hand dipped halfway into the college pudding. The government provides subsidies to colleges in the form of financial aid: low-income students receive Pell Grants of up to $5,550 to attend school, and federally subsidized loans account for most student borrowing. But schools like to maximize their revenue, and there is no reason for them to use this price to make college cheaper. Instead, they can raise their prices in response to the increased subsidy and, in effect, eat the government’s money. This idea is known as the Bennett Hypothesis, and, as with all scholarly literature, everyone disagrees as to how accurately it describes the situation. Recent research from Andrew Gillen at Education Sector (the Bennett Hypothesis 2.0) and NBER (which found that federal aid does increase tuition at private colleges) suggests that the basic idea behind the Bennett Hypothesis does carry at least some truth in practice.

Taken together, there many pressures to push costs up – and very few to push them back down.

The libertarian response to the college cost problem is clear: get the government’s hand completely out of the pudding. If we removed the government’s role, they argue, college education would function more like a market and price would naturally come down due to market forces.

But market forces would not actually function to bring costs down. Due to a whole set of strange demand pressures, particularly at middle- and upper-tier schools, removing the government would simply limit access to low-income students. When viewed along with the important notions of fairness that we associate with higher education (not to mention the economic and social returns), we want and need to have a public presence in higher education.

Imagine you are a parent whose child is admitted to a good school. If you already are or have been one of these, you don’t even need to imagine it. Due to the fact that you want what is best for your children, you will at least consider enrolling your child regardless of the cost. (Exhibit A: Ask my parents). In other words, because we don’t treat our children as cost-maximizing automatons but rather want them to be happy, successful, and able to live fulfilling lives, the higher price is not necessarily going to turn you away from sending your child to that school.

In slightly more economic terms, demand for a quality education is highly inelastic: an increase in price will not lead to an equivalent drop-off in the amount of people who want to enroll. In a 2008 study, Steven Hemelt and Dave Marcotte found that price elasticity at public universities has remained extremely low. They show that a five percent increase in tuition would make only a handful of students leave while bringing in millions of dollars of new revenue for the school.

More basic numbers support this point. All else equal, in theory the increasing price of college over the last forty years should have resulted in fewer people attending. But the exact opposite has occurred: the number of people has increased dramatically. The number of people attending college in 1967 was 4.3 million; in 2010, it was 11.5 million, or a 70 percent increase as a share of total population. Some of this increase has been made possible by increasing financial aid, but financial aid alone cannot account for all of this increase: the average per-student debt load after college has increased over time. In 1990, the median amount of federal debt held by students at the time of repayment was $3,560; in 2011, the same figure was $12,839.

This inelasticity of demand – and the ensuing need to find better ways to keep costs down – is one of the same fundamental problems that health care reform faces. Ezra Klein of the Washington Post describes this inelasticity of demand in terms of our inability to say “no.” As the parent of a prospective college student will tell you, the inability to turn down the best education means that “consumers” have very little ability to drive down prices with their choices. As Klein notes, “Medical care and higher education are the two purchases that families will mortgage everything to make.”

Health care, like education, is also not transferable: You can’t sell your diploma to someone who didn’t graduate, nor can you sell your lack of diabetes to someone who is suffering. This lack of transferability makes determining the value of the good even more difficult. Because education is, as Dylan Matthews of the Washington Post explains, a one-time “experience good” in which the quality is difficult to assess beforehand and the interaction (getting an undergraduate degree) usually only occurs once. This renders the idea of market “exit,” or having consumers not purchase a good in future transactions, much less viable as a strategy of determining price or setting quality.

But the demand problem goes even further: demand for some schools is not only inelastic but actually backwards. A more expensive school is often more desirable than a less expensive one. (In economics, these are called “Giffen goods.”) Part of this is because schools are rewarded for spending increasing amounts of money. Everyone hates the U.S. News and World Reportrankings, but for good reason: “Spending more money can lead to higher rankings,” the Center for College Affordability notes. The existence of these Giffen goods is sometimes referred to as the Chivas Regal effect, in which a higher priced product is viewed as being higher quality even if it is simply just more expensive. Chivas Regal whiskey, apparently, is overpriced.

Similarly, because our notions of quality are both speculative and based on a host of different factors, individuals’ demands for schools also encourage an inexorable rise in prices. It’s not just that students have inelastic demand for colleges; the parts of college they do demand also encourage schools to spend more. Students are more likely to attend a school that has more “consumption amenities” like new buildings and recreational facilities – particularly if the students come from middle- or higher-income backgrounds. The best bet for schools that want to maximize their revenue is to spend a lot of money and then raise tuition, which means that unless we have some type of intervention, we are going to end up with a system of higher education that is only for the rich. Even if we acknowledge that college is not the answer to our economic problems, we do not want a higher education system that only serves a small group of wealthy elites.

Thus, government subsidies are here to stay. Klein writes, “There’s no sustainable way to end government involvement in these areas. The subsidies will always come back because people will always vote them back.” If anything, this is actually somewhat reassuring about the state of humanity: demand for these products is inelastic because families want their children to get the best education possible and are asking the government to help make this possibility a reality.